Idea of the Week: ‘Tis the Season to Begin the Quest for Year-End Bargains

December 19th, 2012 by

Investors are busy harvesting year-end tax losses to set against their portfolio gains, and the pros are doing some “window dressing”. The price declines that are the result of this activity offer thoughtful investors a great opportunity to stop and scrutinize the ranks of these market laggards for any fallen angels: stocks whose attractive fundamentals might not be reflected in current market prices.

Released: December 19 2012
Length: 3 Minutes

‘Tis the season to be window dressing your portfolios, if you happen to be an investment manager with less than two weeks to go before closing the books on 2012.  It’s also the season to find ways to sell stocks that appear likely to end 2012 in the red, in order to generate tax losses that can be set against longer-term gains.  Some investors scrutinize their books during the final trading days of the year scanning for companies whose fundamentals look as if they are deteriorating, but others sell purely and simply to make their portfolios look better, either in absolute terms or on an after-tax basis.

Is all this selling justified, or are there some attractive companies being battered down today that investors may find more attractive come January, once the year-end window dressing is over?  We used StarMine quantitative models to analyze six companies whose share prices have fallen in 2012, and the results suggest that investors may well find some appealing stocks among this group once the dust clears and portfolio managers open the books on a new year.  For different reasons, some of these stocks that represent trends in the market that could appeal to investors in 2013.

Industry Leaders

Humana (HUM.N), a leading in the health care management firm (whose performance is represented by the blue line in the chart below) has outperformed its peers in that industry in terms of total return over the last several years, as indicated in the chart that follows.  Lately, however, Humana has been hit by the uncertainty surrounding the ramifications of Obamacare for its business, as well as some recent downward pressure on margins. That has made the company’s stock vulnerable to both window-dressing and tax-loss selling pressures, but one bad year doesn’t mean that a trend is firmly in place.  Indeed, StarMine’s Relative Valuation Model awards Humana a high score of 86 on a 1 to 100 scale.  On the other hand, Humana scores a mere 9 out of a possible 100 on StarMine’s Price Momentum model, reflecting investors’ discomfort with the stock at this time of the year.  Still, anyone pondering selling the company’s shares short may think again after a look at the fundamentals reflected in the StarMine Short Interest Model (SI), on which Humana scores a healthy 81.  And Humana’s score of 31 on the StarMine SmartHoldings Model, which has been rising, signals that the stock may be becoming more attractive to institutional investors, based on the factors that appear most likely to drive buying by these investors over the next 90 days.

Global Trends

It’s not hard to forecast a scenario that would favor the expansion of the gambling industry worldwide. That kind of trend certainly would augur well for International Game Technology (IGT.N), a global gaming company that has lagged the market (as represented by the S&P 500) by 15% through mid-December of this year. (Still, the company’s stock appears likely to end the year on a more positive note than seemed possible in August, when it was down 36% year-to-date.) The probable expansion of online gaming in the United States, together with the expectations by analysts that casinos will upgrade the caliber of their machines to add more entertainment value, could together serve as long-term tailwinds for the company’s earnings and share price.

IGT’s stock today trades at 7.2 times its forward 12-month cash flow ratio. (The green line in the chart below depicts that ratio between the stock’s price and projected 12-month forward cash flow.) That is well below the 10-year average of 13.5 times. Moreover, that cash flow valuation level tracks the company’s stock price (represented by the shaded area on the chart), and is heading upward – the direction you’d like it to go. Moreover, while the IGT’s current stock price reflects the expectation that the company’s earnings will grow at a 4.8% compounded annual growth rate over the next five years (according to the StarMine Intrinsic Valuation Model), that appears to understate reality. StarMine data, intelligently adjusted for analysts’ earnings growth forecasts, suggests that the actual rate of growth may be closer to an 8.4% annual rate over the same period.

Low Expectations

Staples (SPLS.O) may be a poster child for low investor expectations. The stock has fallen 18% this year, and now trades at a level that implies that the company’s earnings will decline by about 6% annually over the next five years. In fact, analysts currently project that its earnings actually will grow by about the same amount! The company’s quarterly dividend payout of 11 cents per share (which the company has raised in each of the last three years; that increased payout and the stock’s decline has sent the yield up to 3.9%) seems safe, since analysts are predicting that the company’s cash flow will be enough to cover that payout. Obviously, an improving economy would give the company’s stock price an extra boost.

Recovery From Price Shocks

Packaged meat company Smithfield Foods (SFD.N), the world’s largest hog processer, has seen its share price tumble 15% this year, mostly thanks to leaner margins and the higher cost of feed. Some of this may now have been factored into Smithfield’s share price (represented by the blue line in the chart below) and while it remains a volatile stock, Smithfield has generated a total return that is double that of the S&P 500 index since the S&P 500 index hit its post-crisis low in early March, 2009.

Bulls may well find several more reasons to take an upbeat view of Smithfield’s stock.  Historically, the company’s margins and share prices have recovered after price shocks such as those delivered by the surge in corn prices that followed last summer’s drought in the U.S. Midwest. Moreover, even as Smithfield’s shares have declined over the course of 2012, the company’s management seized the opportunity this decline offered to repurchase 10% of its outstanding shares.  Fundamentals appear relatively robust: inventory turnover has remained steady, so any uptick in operating margins will spill over quickly into the company’s bottom line.  As is the case with IGT, Smithfield’s price/cash flow ratio is rising, which augurs well for the future direction of its share price.  Finally, the StarMine Relative Valuation Model gives Smithfield a very high score of 93 out of 100 among all U.S. companies they track. True, as recently as November, the StarMine Analyst Revisions Model (ARM) ranked it only 30 out of a possible 100.  As analysts take a more upbeat view of Smithfield, that has reversed itself, however, and the company’s current ARM score is an impressive 95.

Potential Value Traps

The financial media loves to talk about ‘value traps’; stocks are priced at a discount but that go nowhere or whose prices fall still further. Some companies earn that moniker for good reasons, such as those that analysts and investors believe to be in the midst of a secular decline.  One such is money transfer company Western Union (WU.N). The company may appear attractive from a valuation standpoint, since its stock has fallen 30% over the course of 2012, causing it to move up the ranks on some valuation models, including StarMine models. The concept of relative valuation implies a tendency to revert to the mean, or follow a cyclical pattern, rather than marking the start of a new, longer-term secular trend.  It’s hard to conceive that the electronic payments business today and in the future bears any resemblance to the business that Western Union helped to pioneer many years ago. The experience of Eastman Kodak in the camera and film business, and Blockbuster in the video rental business (not to mention the myriad buggy whip manufacturers) has proven that pioneers don’t always remain pre-eminent, and Western Union no longer is the sole player in consumer-to-consumer money transfers, or even the cheapest player. The company’s management is trying to modify its business model to adjust to the new realities, including changing technologies and business processes. Sometimes a stock trading at a discount to recent prices and to its apparent value is indeed a bargain, but it’s important to remember, too, that some value stocks might remain “values” for a very long time, and never realize their potential. If you suspect that you’re stuck in a value trap, the final evidence that you’re right is delivered by the passage of time.

Execution Risk

Game software and services company Electronic Arts (EA.N) may appear to offer investors tantalizing value after its 35% drop. But the analysts who follow the company and issue earnings forecasts are sending mixed signals.  On the one hand, the company scores only 22 out of a possible 100 on StarMine’s Analyst Revisions Model.  Still, none of the 28 analysts whose ratings on the company are tracked by StarMine rate Electronic Arts as a “Sell” or “Strong Sell”.  At least for now it appears as if the analyst community may be giving management the benefit of the doubt, as the company tries to adjust to the new realities of the gaming market place and rapidly changing consumer preferences.  For instance, Electronic Arts may need to make significant adjustments to reflect the growing interest in social gaming, as well the rate at which those gamers embrace newer gaming consoles.

As 2012 draws to a close and investors begin to prepare themselves for a new year in the financial markets, it may be worth remembering the words of a legendary value investor drawing a distinction between the kind of short-term movements that may be weighing on some stocks today, and the longer-term trends that signal a real change in direction.  “In the short-run, the market is a voting machine,” Benjamin Graham declared. “But in the long run, the market is a weighing machine.”